Managers of buyout funds and other private equity funds give their investors an 8% preferred return on their investment before they take a share of any additional profits. Venture capitalists, on the other hand, offer no preferred return. Instead, VCs take their cut from the first dollar of nominal profits. This disparity between venture funds and buyout funds is especially striking because the contracts that determine fund organization and compensation are otherwise very similar. Are VCs receiving pay without performance? Is the missing preferred return evidence that VCs are camouflaging rent extraction from investors?

This Article argues that the missing preferred return reflects an inefficiency in venture capital compensation practices. Making VC pay subject to a preferred return would help investors screen out bad VCs and would better align the incentives of VCs with their investors when VCs are courting and negotiating with portfolio companies. The screening effect may be less important for VCs with strong reputations. Even for elite VCs, however, the status quo still appears to be inefficient, albeit in a different way. If a fund declines in value in its early years, as is usually the case, the option-like feature of the carried interest distorts VC incentives. Compensating VCs with a percentage of the fund, rather than just a percentage of profits, would eliminate this distortion of incentives. Thus, the current industry practice is puzzling. None of the usual suspects like bargaining power, boardroom culture, camouflaging rent extraction or cognitive bias offers an entirely satisfactory explanation. Only by peering into a dark corner of the tax law can we fully understand the status quo.

The tax law encourages venture capital funds to adopt a compensation design that misaligns incentives but still maximizes after-tax income for all parties. Specifically, by not recognizing the receipt of a profits interest in a partnership as compensation, and by treating management fees as ordinary income but treating distributions from the carried interest as capital gain, the tax law encourages funds to maximize the amount of compensation paid in the form of carry. One way to do this is to eliminate the preferred return, thereby increasing the present value of the carried interest, which in turn allows investors to pay lower tax-inefficient management fees.